Over four years ago, in a desperate response to the credit crunch, the UK government started creating cheap money. In a programme known as quantitative easing (QE), the Bank of England started buying back gilts in massive volumes. This has had the effect of reducing yields on gilts to miniscule levels. Last year the yield on five-year gilts fell below 1%. Currently it is 1.3%. Simultaneously, the UK Base Rate has been kept very low. The rate has been 0.5% for over four years.

At some stage this programme of artificially low interest rates will have to stop. The markets suffered sharp falls recently when the US government hinted that their own version of QE would soon come to an end as the US economy recovers. This raises two big questions for equity investors:

How high would interest rates be without QE?

What effect would the new level of interest rates have on equity values?

I have conducted research to answer the first of these questions. This research shows that, without QE, there is a very strong correlation between expected levels of inflation and gilt yields. This is hardly surprising because generally investors look for a real return.

Currently investors are being short-changed as the yield on gilts is heavily negative in real terms. It is only the capital gains which gilt investors have made as a result of interest rates falling which have prevented the gilt market from collapsing. Mathematically prices must increase as yields fall. However, gilt rates have fallen so low that there is now more downside risk than upside potential in gilt prices.

My research has also shown that the higher the expectations of inflation, the higher the real return on gilts which investors demand. The Bank of England publishes daily the market expectations of inflation. Currently the market expects inflation to average 2.8% over the next five years. Without QE this expected inflation would lead to an annual redemption yield of around 5.2% on gilts redeeming in five years. This rate is clearly significantly different from the current rate of 1.3%.

To answer the second question – the impact that an increase in five-year gilt yields to 5.2% would have on equity values – it is necessary to understand what factors determine equity values. An increase in interest rates primarily reduces equity values because it makes it comparatively more attractive to hold gilts. Or to put it another way, the opportunity cost of holding equities increases. The secondary impact on equity values is that higher interest rates will lead to lower profits for those companies which borrow.

In my book How to Value Shares and Outperform the Market, I explain how to build a spreadsheet to calculate the intrinsic value of UK shares. One of the key factors in the valuation is the redemption yield on five-year gilts. It is easy to change the current yield from 1.3% to 5.2% to see the impact of this change on intrinsic share values. If you don’t want to bother with building a spreadsheet, my ShareMaestro software will do these calculations for you. In a nutshell, this large increase in gilt yields would reduce the value of the FTS100 by 17%.

Whilst the prospective increase in interest rates will reduce the intrinsic value of equities, it does not necessarily mean that investors should shun UK equities. The current intrinsic value of the FTSE 100 is so high compared with the current market price that, unless there were a significant downturn in the economy, the FTSE 100 would remain good value even if five-year gilt yields were to increase to 5.2% tomorrow.

Of course, in the short term, the market might well crash if a sudden rate increase such as this were to occur. However value-investing is about investing for the long term. Value investors should see any such crash as a buying opportunity.